In this recent Q&A session, ETF Trends Director of Research Dave Nadig sat down with Bruce Bond, Co-founder and CEO of Innovator ETFs, to discuss a new generation of accelerated return ETFs.
Describe the pattern of potential returns here in the cleanest elevator pitch you can.
Innovator Accelerated ETFs seek to provide 2x or 3x the upside return of SPY (SPDR S&P 500 ETF Trust) or QQQ (Invesco QQQ Trust) to a cap, with approximately single exposure to the downside, over an annual or quarterly outcome period.
The initial launch here is annual. How should investors think about “mid-cycle” investing in these products? How should they evaluate them?
Two of our initial four Accelerated ETFs reset annually and the other two come with a quarterly reset. The Quarterly ETFs will have shorter outcome periods than the other two Accelerated ETFs™. The shorter outcome period of the Quarterly ETF means it will follow the underlying reference asset more closely, but will have lower starting caps. Having access to both an annual and a quarterly reset ETF offers the ability to make mid-cycle adjustments.
You’ve had huge success with the core Defined Outcome ETF series, should investors in those products be thinking of moving over to these?
Not necessarily. The core defined outcome series is built on providing buffered exposure, which has proven to have a lot of appeal to investors who need or want exposure to the market’s upside, but with a measure of downside risk management.
We see the Accelerated ETFs addressing a different risk: low equity market returns. It’s common to hear of investment strategies described as offering the benefit of achieving market-like returns, but with less risk. In the case of Accelerated ETFs, we think of them as offering the same level of downside risk as the market, but with a potential for higher returns for any level of equity market return below the fund’s cap over the full outcome period.
There’s never a free lunch: how am I paying for this doubled up exposure on the upside? What’s the “give” for the “get”?
You’re exactly right about there being no free lunch. In order to ‘get’ the double upside exposure, you have to ‘give’ some of the upside to finance it. This is done in two ways: the first way is to give up the dividends, and the second way is to sell out-of-the-money call options[1] that create a cap on the upside.
Are there any tax implications investors should be aware of?
The tax efficiency of the ETF gives investors greater control to determine when they want to incur a capital gains tax. Our ETFs automatically roll into the next outcome period, in contrast with other product structures that offer defined outcomes that mature and incur a capital gain at the end of the outcome period. This means investors can hold the ETFs indefinitely, compounding their return and controlling the timing of when they incur a capital gain.
Since these products provide leveraged exposures, do investors need to be worried about daily rebalance math (I know the answer, but would love to get this articulated from Innovator).
No, these products are suitable for long term buy and hold investors. Traditional leveraged exposures are leveraged on both the upside and the downside. If it’s double exposure, the investor is supposed to receive approximately 2x the return on the upside and the downside, on a daily basis. One of the effects of a daily rebalance is that returns can end up being distorted over longer periods of time. For example, there was a stretch from March through May in 2020 when the S&P 500 had generated a positive return, but the 2x version was negative. That’s not a knock on those strategies; they do what they’re designed to do. But they’re designed to be more of a trading product than a long-term, buy-and-hold, core equity product.
The Accelerated ETFs aren’t designed to provide 2x returns on a daily basis and so and aren’t exposed to the counterintuitive longer-term effects of daily leverage resets.
Is there anything that could catch investors by surprise here? Could something change in the options market that would keep the products from delivering as expected?
That’s an important question and is of course a function of investor expectations. One of the features of options that can sometimes be overlooked is time value and its effect on how responsive an option is to the underlying asset. With 1-year options, like the ones held in our Defined Outcome ETFs (including the Accelerated ETFs), they are always less sensitive to movements in the underlying asset early in the outcome period, and become more sensitive the closer they get to the end of the outcome period. That doesn’t prevent the products from delivering as designed, but their initial movements might surprise investors who are looking at these products for the first time.
From a broader options market perspective, the options held in the Defined Outcome ETFs are guaranteed for settlement by the Options Clearing Corporation (OCC), which has been deemed a systemically important financial market utility (SIFMU) by the U.S. Government. This means the Federal Reserve Board will intervene in the event of significant liquidity or stability issues, of which there have been none since the OCC’s inception in 1973. The Federal Reserve Board also holds SIFMUs to higher standards of risk-management, authorizes a Federal Reserve Bank to service and maintain an account for them, and consults on their inspections. If there’s something happening in the options market that prevents options from delivering as expected, we’d all probably have bigger issues to deal with.
Who are these products for? What could they replace in a portfolio?
I believe that these products deliver value for all types of equity investors. The SPY 2x has an average cap of about 20% so it is for any investor who thinks the market may not reach that level over the next year or who wants to increase their likely hood of achieving that potential return. These products help assure certain levels of performance which we believe is very attractive in portfolio construction and planning. We suspect there are a lot of investors who will find it a compelling tradeoff to be capped in the range of 18% to 22%, knowing they’ll have the potential to outperform if the market returns anything less than the cap over the course of the full outcome period. I also think some investors may want to dump their active managers for the outperformance potential of the Accelerated ETFs.
For more on defined outcomes and accelerated strategies, watch the recent webcast New Developments in Defined Outcome ETFs here.
1. An out-of-the-money call option is a call option that has a strike price above where the market is trading at.
If the Outcome Period has begun and the Fund has experienced an accelerated return, an investor purchasing Shares at that price may be subject to losses that exceed any losses of the Underlying ETF for the remainder of the Outcome Period and may have diminished or no ability to experience further accelerated return, therefore exposing the investor to greater downside risks.
The funds only seek to provide their investment objective, which is not guaranteed, over the course of an entire outcome period. Investors who purchase shares after or sell shares before the end of an outcome period will experience very different outcomes than the funds seek to provide.
The funds have characteristics unlike many other traditional investment products and may not be suitable for all investors. For more information regarding whether an investment in the fund is right for you, please see Investor Suitability” in the prospectus.
The Funds are designed to provide point-to-point exposure to the price return of a reference asset via a basket of Flex Options. As a result, the ETFs are not expected to move directly in line with the reference asset during the interim period. Additionally, FLEX Options may be less liquid than standard options. In a less liquid market for the FLEX Options, the Fund may have difficulty closing out certain FLEX Options positions at desired times and prices.
Fund shareholders are subject to an upside return cap (the Cap) that represents the maximum percentage return an investor can achieve from an investment in the funds’ for the Outcome Period, before fees and expenses. If the Outcome Period has begun and the Fund has increased in value to a level near to the Cap, an investor purchasing at that price has little or no ability to achieve gains but remains vulnerable to downside risks. Additionally, the Cap may rise or fall from one Outcome Period to the next. The Cap, and the Fund’s position relative to it, should be considered before investing in the Fund. The Funds’ website, www.innovatoretfs.com, provides important Fund information as well information relating to the potential outcomes of an investment in a Fund on a daily basis.
The Funds only seek to provide shareholders that hold shares for the entire Outcome Period with their respective buffer level against reference asset losses during the Outcome Period. With XBAP, you will bear all reference asset losses exceeding 9%. Depending upon market conditions at the time of purchase, a shareholder that purchases shares after the Outcome Period has begun may also lose their entire investment. For instance, if the Outcome Period has begun and the Fund has decreased in value beyond the pre-determined buffer, an investor purchasing shares at that price may not benefit from the buffer. Similarly, if the Outcome Period has begun and the Fund has increased in value, an investor purchasing shares at that price may not benefit from the buffer until the Fund’s value has decreased to its value at the commencement of the Outcome Period.
The Funds’ investment objectives, risks, charges and expenses should be considered carefully before investing. The prospectus contains this and other important information, and it may be obtained at innovatoretfs.com. Read it carefully before investing.
Innovator ETFs are distributed by Foreside Fund Services, LLC.